[9 marks] “Inflation is always

Economics Nobel laureate Milton Friedman said inflation isalways, and everywhere, a monetary phenomenon.Time and again he hasbeen proved wrong. For the last decade, central bankers in the US,the eurozone, Japan and China have been pumping their economieswith money without inciting inflation.Economists have long assumedthat a trade-off exists between unemployment and inflation. It isnot possible to attain full employment, they argue, without riskinghigh inflation. Likewise, economies cannot hope to bring downprices without inflicting unemployment.

This inverse relationship (also knownas the Phillips Curve,named after economist A W Phillips) appears to be breaking.Unemployment in the US has reached the lowest since 2000. Butinflation continues to remain close to 2%. The eurozone had a coreinflation (excluding food and energy) of less than 1%. Even as theeurozone economies perked up in 2017, the core inflation ratedeclined further.

Have economists been wrong all along, or has something changedin the economy that has weakened the expected link betweeninflation and unemployment? Perhaps they have been wrong all along.Who knows? It is, after all, not an exact science. You cannot testeconomic theories in labs in a controlled environment.

We must look for non-monetary explanations. In recent years,three aspects of the new economy technology, globalisation, anddemographic trends have created strong deflationary pressures.Technological progress is often deflationary. But it is difficultto measure its impact as new products have better quality and newfeatures than the ones being replaced.

The prices of personal computers, television sets and cellphones have been falling even as quality improved.

Online retail stores have imposed deflationary pressures on thebrick and-mortar economy. They have the advantage of locating inareas with the lowest land prices as well as labour costs. Themantra of the online retailers (Amazon, Alibaba, Flipkart, etc) islow margins combined with enormous sales.

Appy Economy Technology has also resulted in what is called thesharing economy, where individuals can rent assets owned by othersfor short periods. Airbnb, now the largest provider of short-termresidential accommodation, is an example.

Airbnb has over three million lodging listings in 65,000 citiesand 191 countries, many times the size of any major hotel and motelchain anywhere in the world. Prices at Airbnb are fixed by theowners and have been much lower than hotel and motel prices.Further, AirBnB’s vast capacity has tamed the rest of the hotel andmotel industry from raising rents.

Uber, the largest private taxi service in the world, is anotherexample of the sharing economy. Uber’s mantra is also scale withlow margins: it operates in 84 countries and 737 cities.It hascreated a model in which individuals use their personal cars toprovide taxi service. In most cities, Uber fares are often half theprivate taxi fares. With competition from Uber, private taxicompanies are not able to execute routine increases in fares asthey did in the pre-Uber world. Competition from other app-linkedtaxi companies like Sewa, Ola, Uno, Lyft and Gett has furtherchecked fares from rising.Globalisation has inflationary as well asdeflationary effects. By bringing prosperity in emerging economies,globalisation increased demand and inflation. Indeed, inflation inthe 2000s was partly an outcome of rising commodity demand fromChina and other fast-growing developing countries.But there are other aspects of globalisation that are deflationary.Freer trade and tariff reductions lower inflation. Outsourcing oflabour-intensive operations to countries with cheap labour is alsodeflationary.

Synergies of production across rich and developing countriesthat globalisation has created have moderated wage growth acrossrich countries.

Whoever thought demography would have anything to do withinflation? But recent demographic trends have also createddeflationary pressures.In ageing economies across Europe, the population pyramids arebulging at the top and becoming narrower at the bottom. The shareof older people in the population is rising and of younger peopledeclining.Because old people are net savers and young people net borrowers,many ageing societies are in what economists call a saving glut,resulting in low interest rates. Old people buy less, reducinggross demand and inflation.

Immigration, a key source of labour supply in most of Europe andthe US, is yet another factor. While its impact is modest comparedto the impact of technology and globalisation, immigration alsolowers wages and wage growth.Inflated Worries Price expectations are an important cause of lowinflation. It is the most common explanation put forward by centralbankers.Price expectations are driven by past trends. The currentlow-inflation expectations are driven by low inflation of the lastdecade. Once prices begin to rise, the expectation will change andinflation will pick up further.But then, you might ask, what is so bad with low inflation? Why arecentral bankers waiting for inflation to reach its target withbated breath? Two main reasons: one, deflation limits the abilityof central bankers to provide monetary stimulus in the nextrecession.Two, low interest rates drive money to stocks, furtherfeeding into asset price bubbles.